Interview conducted by Philip Pilkington, a journalist and writer based in Dublin, Ireland.

Philip Pilkington: The overarching thesis of your book The End of Loser Liberalism is quite a provocative one. This isn’t just a book about economics as such. Instead, if I were to venture using a term that appears to be coming back in fashion, it’s a work of political economy. You write that the current political debate – wherein the left are seen as restricting and constraining the ‘free market’ while the right are seen as letting it free to work – is completely skewed. You write that liberals and progressives need to take a different line on this. Could you explain this basic premise in a little more detail, please?

Dean Baker: The conventional view is that conservatives place a huge value on market outcomes. It is common for progressives or liberals to deride them as “market fundamentalists”, as though they worship the market as an end in itself. By contrast, liberals/progressives are supposedly prepared to use the hand of government to override market outcomes in order to promote goals like poverty reduction or equality. I argue in the book that this view is completely wrong, and worse that it plays into the hands of the right.

I argue that the right has quite deliberately structured markets in a way that have the effect of redistributing income upward. The upward redistribution of the last three decades did not just happen, it was engineered.

I’ll give a few quick examples here. It is common to say that the right deregulated finance. This is only partly true. What they did was to take away the restrictions on what financial companies could do, while leaving in place the government insurance – explicit and implicit – that provides the necessary backdrop for a functioning financial market. In effect, they allowed the banks to have insurance without paying for it.

When most of the country’s major banks were literally on the edge of insolvency in the fall of 2008, very few of the “free market fundamentalists” were saying that we should let the market run its course. They were demanding that Congress, the Fed, and the FDIC do whatever is necessary to backstop the banks and keep them operating. The government’s intervention at that point prevented a full-fledged financial meltdown. This was the right thing to do for the economy, but it could have been done in a way that fundamentally altered the financial industry, so that the huge paychecks for top executives and high-flying traders would be rarer and smaller. Instead, the bailouts largely left the financial sector intact.

Now that the crisis is behind us the financial sector is again arguing that they should not be regulated. But, does anyone doubt that if Citigroup or Goldman’s bad trades brought them to insolvency that the government would again intervene to support these banks? It is absurd for progressives to ever accept this as an argument about whether we want government intervention or the market. Both sides want government intervention, the difference is that the right wants it to favor the banks’ management and shareholders while progressives want to ensure that it benefits the public as a whole.

To take another example: prescription drugs are expensive entirely because of government granted patent monopolies. The United States is spending close to $300 billion a year for drugs that would sell for around $30 billion a year in a free market. Incredibly, the right has been so effective in distorting public debate that restrictions on these monopolies, such as government negotiated prices for public health programs or explicit price controls, are seen as restrictions on a free market.

Patent protection of course serves a purpose: it is a way to finance the research and development of new drugs. However, it is nonetheless a government intervention into the market and, in fact, a very big one at that. We can think of the gap between patent protected prices and free market prices as being effectively a tax, which comes to more than $250 billion a year (5 times the size of the Bush tax cuts for the wealthy) and is projected to grow rapidly over the next decade. The biggest beneficiaries of this tax are the shareholders of the drug companies, top executives and a few lucky scientists.

Once we recognize that patent protected drug prices are not the result of a free market, but rather conscious government policy, we can ask the right question, which is whether there are better ways to support bio-medical research. The idea that we can finance research through alternative mechanisms should not be alien, since we already spend $30 billion a year on bio-medical research through the National Institutes of Health. But to have a serious discussion we have to recognize that the supporters of patent monopolies on prescription drugs are not free market fundamentalists. What we are debating is the best form of intervention, not the government versus the market.

To take a third case, the value of the dollar is enormously important in determining the distribution of income. The over-valued dollar is the main factor behind the US trade deficit. It swamps everything else we may or may not want done in terms of trade policy, competitiveness policy or industrial policy. If the dollar is over-valued by 30 percent it is roughly the same as giving a 30 percent subsidy on all the goods that we import while imposing a 30 percent tariff on all of our exports. It is incredibly difficult for domestic producers to overcome this sort of disadvantage.

Furthermore, it is not an accident what sectors of the economy are exposed to international competition. In principle, almost any sector of the economy can be opened up to trade. For example, in the case of health care, we can have laws that make it very easy for foreign born doctors to train to US standards and then practice wherever they want in the United States. We can also set up a legal and institutional structure that makes it easy for people to travel overseas for major operations to take advantage of the much lower prices charged in many countries.

However, neither path has been pursued in our trade negotiations. The main area where our negotiators wanted ‘free trade’ was in manufactured goods. This put US manufacturing workers in direct competition with their much lower paid counterparts in the developing world. This policy has the predicted and actual effect of lowering the wages of manufacturing workers in the United States. And since manufacturing has historically been a source of relatively high paying jobs for the 70 percent of workers without college degrees, this trade policy put downward pressure on the wages of this group of workers as whole.

This downward wage pressure is aggravated by the over-valuation of the dollar. The over-valuation of the dollar is conscious policy that dates back from Robert Rubin taking over as Treasury Secretary in the Clinton years. Rubin publicly advocated a high dollar since his first days as Treasurer, but he got the chance to put real muscle behind this policy through his engineering of the bailout following the East Asian financial crisis. Rubin’s deal was that the countries of the region would repay their debts in full (no write-downs), but we give them the ability to do this by allowing them to run huge trade surpluses with the United States.

The harsh treatment of the East Asian countries was a warning to the rest of the developing world. They adopted a policy of accumulating massive amounts of reserves to avoid ever being in the same situation as the East Asian countries. This means lowering the value of their currencies against the dollar so that they could run large trade surpluses. This continues to be the policy pursued by most developing countries so that the flow of capital is running from poor countries to the United States, rather than the other way around as the story goes in economics textbooks.

In short the United States has deliberately put in place a trade and dollar policy that disadvantages the bulk of the workforce for the benefit of employers, importers and those looking to invest overseas. The fact that manufacturing workers have done badly over the last two decades has nothing to do with random market outcomes. It was the result of deliberate policy.

The point of the book is that progressives must focus on these and other ways in which the right has structured the market to benefit the wealthy at the expense of everyone else. The failure to recognize that the market has been rigged to redistribute income upward leads to both bad policy and horrible politics.

We should focus on the key factors that determine market outcomes, not just accepting the outcomes and then using the government to pick up the pieces after the fact. There is a lot to be said for the right’s view of the market. It is an incredibly powerful instrument and we should be looking to structure it in a way that produces the outcomes we desire rather than just abandoning this task to the right. This is where the real action is: tax and transfer policy will always be a very distant second in its implications for income inequality.

From a political standpoint, if we don’t challenge the right’s structuring of the market we end up being ‘loser liberals’. We play the game, but then are unhappy with the outcome so we want to tax the winners to help the losers. That is truly awful politics, but this is where much of the left has been over the last three decades.

PP: Why do you think the left has been playing this game for so long? Do they see tax policy as being a silver bullet simply because it was, together with the other component of fiscal policy – that is, government spending – their weapon of choice since after the New Deal?

DB: I think there are three reasons.

1) There was a real shift in the 70s/80s in which the right actively embarked on a policy to redistribute income upwards. In other words, the attack on the incomes of the working class/middle class is relatively recent.

2) It is always possible to win something in the tax/spending battles, even if it is trivial. From the logic of the advocacy world, this can be everything.

3) The academic world, first and foremost the economics profession, helped to conceal the policy decisions that underlay the upward redistribution of the last three decades. They have helped to conceal that this upward redistribution was in fact the result of policy, as opposed to the natural workings of the market.

On the first point, there was little reason for progressives to give much thought to the underlying issues affecting the distribution since most of the population shared in the gains of growth through the 40s, 50s, 60s, and into the 70s. It was only in the last three decades that the right was actively changing the rules to make sure that income flowed upward. The progressive groups that could have responded, most importantly labor, were basically caught flatfooted. These were playing the same game that they had been always been playing, as though the rules had not been changed. Obviously this does not work out very well.

The second point is something that people outside of Washington may find difficult to understand, but inside the Beltway it makes perfect sense. We have all sorts of liberal/progressive organizations that exist to promote one or another progressive cause. Their top people all draw nice six-figure salaries and are important people who get invited to important meetings with other important people. Being able to get a few nickels or dimes for one or another program justifies that they are doing something useful. It keeps money flowing from funders.

The constituencies that they ostensibly represent may be getting killed because the Fed is raising interest rates to throw them out of work and lower their wages, or trade and dollar policy is taking away their jobs and depressing their wages, but no one is going to talk about that. Instead, the important people at the liberal/progressive organizations can boast about getting a few more bucks for one or another government program. This is a great win-win for everyone except the people who are screwed.

The third point has to do with the corruption of academia. It has produced a vast body of literature that studiously avoids asking most of the questions that I raise in The End of Loser Liberalism. There is virtually no literature that examines the efficiency of patent protections for prescription drugs relative to other mechanisms for financing research. This is a policy that raises the price of prescription drugs by more than $250 billion a year, yet almost no one examines it. You will find endless studies that look at the cost of trade barriers on shoes, but next to nothing on protectionist barriers that cost 100 times as much and jeopardize lives. Most people, including economists, never even give the issue of patent protection a moment’s thought. They are perfectly happy going through life as though this policy is something handed down to us by God.

The same is true for most of the other issues that are central in the book. The idea that Federal Reserve Board policy can affect income distribution is virtually taboo in the economics profession. Yet, we can clearly show that high rates of unemployment disproportionately affect those at the middle and the bottom of the wage distribution.

In the same vein, economists do their best not to know that foreign professionals are excluded from the United States by deliberate policy. I have had prominent economists tell me that there are no barriers because the person in the next office to them was born in India. In other contexts, economists would ridicule someone who said something so silly – it would be like saying that we had free trade in agriculture because we can buy tomatoes grown in Mexico. This is obviously ridiculous, but somehow economists think that this sort of argument makes sense when it applies to people like them.

Anyhow, the fact that the economics profession overwhelmingly supports the view that the rules that redistribute income upward are simply natural facts of the economy and market makes it much more difficult for people to challenge this position. Their arguments are easily dismissed by the media and others in authority positions because ostensibly independent experts ridicule their position.

In short, the game is stacked in the outcome and it is also stacked against those who would call attention to the fact that it is stacked. This is not an easy road to follow, but if the point is to actually have an impact, it is the only road.

PP: That leads us nicely onto our next question, which relates more specifically to a point you raise in the book and elsewhere: what is with commentators on the origins of the present economic crisis? You point out in the book that they all seem to think that this was first and foremost a financial crisis. But it was not. First and foremost it was a mortgage bubble that took place in the ‘real economy’. Everything that took place in the financial sector – and I don’t want to excuse any of this, as there was plenty of grime – but everything that took place in the financial sector was really a symptom of underlying weaknesses in the ‘real economy’.

When I read this in the book it reminded me of what is going on today in Europe. I had a long conversation with a bunch of economists from many of the leading banks a few weeks ago and it took an almost Herculean effort to convince them that, at root, this was not a banking crisis. It was due to a flaw in the structure of the Eurozone and it only became a banking crisis after the fact, as it were.

I mention this because I think that this desire to see the current problems we face through the lens of finance pure and simple runs very deep. What do you make of it? Is it evasion on the part of commentators and the economics profession? Why such a tremendous blind spot in this regard?

DB: I think the focus on finance does two things. First, it provides a cover for the failure of the people who carry through and comment on economic policy. Finance can be complicated, bubbles are simple. The second reason is that it avoids a discussion of the underlying structural imbalances that few want to address.

On the first point, the real story of the economic crisis was not that it was too hard to see it coming, it was too easy. Economics is about making simple things complicated. The complexity both excludes most of the public from policy debates and also gives economists their status as masters of a complex discipline.

The basic housing bubble story was very simple. We had a sharp divergence from a 100-year long trend in which nationwide house prices had just kept even with the rate of inflation. Supply and demand in the housing market could not explain these rises. There was no remotely comparable increase in rents, which further undermined any explanation in terms of the fundamentals. And vacancy rates were already at record highs even before the crash, showing that inadequate supply could not possibly explain the run-up in prices.

All of this should have been easy to see. Furthermore, it should have been easy to see that the bubble was driving the economy. Housing construction was at a near record pace from 2002-2005, a rate that was completely inconsistent with the rate of household formation during these years. And, housing bubble wealth had driven the savings rate to near zero as homeowners spent based on the $8 trillion in bubble generated wealth.

It was easy to see that there was a bubble, that it would burst, and that it would be a huge hit to the economy when it did, since there is nothing to quickly make up a loss of demand of 6-7 percent of GDP (which translates to $900bn to $1,050bn). It would be embarrassing for economists to say that they missed something that was right in front of their eyes, so rather than talk about the bubble, we hear discussions of the financial crisis. Of course collaterized debt obligations (CDOs) and credit default swaps (CDSs) can get very complicated. So, we get that it was all a very confusing picture and no one knew what was where, and then it all blew up. This gives the blanket “Who could have known?” amnesty to all the people who absolutely should have known.

While the financial crisis part of the story is of course true, it is secondary. There are countries that had relatively well-regulated financial systems, most obviously Spain, that are suffering every bit as much as the US. Spain’s problem was that it had a massive housing bubble driving its economy just like the US at the time.

The other part of the story is that no one wants to talk about the real imbalances that underlie the bubble economy. In the US it was a story of both weak wage growth, which limited consumption demand that was not induced by bubble wealth, and also a massive trade deficit. As a simple matter of income accounting, as long as the US has a trade deficit it must have either budget deficits or negative private savings, or some combination.

Since budget deficits and negative private savings are both seen as undesirable outcomes, any focus on the fundamentals would invariably turn toward getting the trade deficit closer to balance. And the textbook remedy is a lower-valued dollar. However, a lower dollar is bad news for the financial industry, for the firms (e.g. Wal-Mart) that have low-cost supply chains in China and elsewhere, and the yuppies who want cheap trips to Europe.

For this reason, we get a focus on finance and then lots of surprised economists who cannot understand why the economy is not recovering. In many cases we get almost a mystical story that financial crises doom economies to slow growth, as though there is some curse of a financial crisis that over-rides the basics of economics. Of course there is no such thing – there is just political opposition to pursuing the policies that would boost growth.

PP: Of course, the real irony here is that, as many have noted, mainstream economics models do not even take into account private sector debt imbalances, financial instability and financial crises. This makes it even more remarkable that the economists and the commentators have turned to these phenomena as scapegoats.

But that’s just the beginnings of the contradictions of this focus on finance. These days everyone – not just in the US, but in other crisis-stricken economies too (Ireland, where I’m from, being a case in point) – is talking about getting credit flowing again. But you’ve written in the book that there is, in fact, not only no shortage of credit, but also that there is no shortage of access to credit for those that desire it. Perhaps you could talk about this a little.

DB: I will focus on the situation in the United States since I don’t want to pretend to be an expert about credit conditions in Europe. I’ve always posed the same question to those who say that lack of access to credit is the reason for the prolonged slump, what is the evidence?

In the case of housing, the argument is that people can’t get mortgages. There is no doubt that mortgage conditions are tighter than in the peak years of the bubble, but of course we would want them to be. The question is whether there are people who would have been able to get mortgages in the pre-bubble years who are not able to get them today.

The evidence is from the Mortgage Bankers Association mortgage application index and this indicates that such is not the case. This is an index that measures applications for mortgages at banks and these account for more than half of all mortgages issued. The important part of the story is that it measures applications, not mortgages issued. If it really were the case that otherwise qualified borrowers were having difficulty getting mortgages then we should expect the ratio of applications to house sales to be soaring. The reason is that many homebuyers would have to put in two or three applications to get a single mortgage. Some people would put in multiple applications and still be unable to get a mortgage. But in actual fact we don’t see this pattern at all. Mortgage applications have pretty much tracked home sales downward. This would seem to imply that the potential homebuyers who are unable to get mortgages are the exception, not the rule.

In the case of businesses, it is important to realize that the United States is much less dependent on bank credit than most other countries. It is not only the largest corporations, but many mid-size corporations have direct access to the credit markets by issuing bonds and commercial paper. For these companies the conditions of the banks is pretty much irrelevant. If we want to know about their access to capital we just have to look at the interest rate on corporate debt. And this interest rate is very low right now, measured in either real or nominal terms. (The nominal interest rate on 10-year Baa bonds as of October 28, was 5.33 percent, lower than at any point before the crisis.) With interest rates this low, we know that firms that account for close to half of GDP have no problem getting access to capital.

Furthermore, if smaller firms were constrained by their lack of access to capital, but larger firms had access at very low cost, then there are a couple of things we should be seeing. First, many large firms would be extending credit to smaller firms with whom they do business. This could mean that a manufacturer extends credit to its suppliers so that they have the money needed to maintain production. Or alternatively, they could extend trade credit to retailers, allowing them to make payments after goods are sold. The other thing we should be seeing is that larger firms are rushing into markets to take advantage of the weakened state of their smaller competitors. This would mean that big retailers like Wal-Mart and Starbucks would increase their expansion plans, as would chain restaurants, because smaller competitors lack the capital to take advantage of the business opportunities that exist.

In fact, we are seeing the opposite. All the major chains have cut back their expansion plans. This is very hard to reconcile with the credit access story.

Finally, the businesses themselves don’t say that credit is a problem. The National Federation of Independent Businesses has been doing a survey for more than a quarter century that asks business owners what their biggest problem is. Only around 3 percent answer the availability or cost of capital.

In short, the evidence does not support the contention that the lack of access to capital is a major factor constraining the economy right now. Furthermore, if we look at investment in equipment and software, it is almost back to its pre-recession share of GDP, which is quite impressive given the extent of excess capacity in most sectors. So, the credit crunch story is a theory unsupported by evidence that seeks to explain a problem that does not exist.